Why RBI will continue to remain a hawk...

(Apr 2, 2014)

In this issue:
» Are US stock markets rigged?
» Takeaways from the Yellen speech
» Are IIP figures credible?
» Black money to account 1/3rd of the money to be spent in upcoming polls
» ...and more!

00:00

After yesterday's status quo move, where RBI left key rates unchanged, there was a slight disappointment across the street. With inflation cooling down and growth slowing, many expected RBI to adopt a dovish stance. However, RBI governor continued to remain hawkish as he stressed on factors that could potentially derail the declining trend in inflation.

A hawkish stance means that RBI will not lower interest rates in the near to medium term unless inflation settles down within its comfort zone. While the Consumer Price Index (CPI) inflation may have declined to 8.1% for the month of February from 11.8% a year ago, core inflation has hovered around 8%. And this indicates that inflationary trends in the economy have failed to subside. Core inflation excludes the impact of food and fuel inflation, which happen to be most volatile. Thus, it is an indicator of underlying long term inflation.

Apart from core inflation, even food inflation which has subsided for the time being, is likely to rear its ugly head again. The fears of El-Nino are getting stronger by the day. Concerns over scanty rainfall have also emanated recently. This is likely to raise food prices. Higher farm gate prices are not helping either.

When it comes to fuel inflation, the situation is slightly better. Appreciating rupee has made imports cheaper. As a result, petrol prices were cut recently while the decision to hike diesel prices was postponed. However, international crude prices being highly volatile and India being a net importer of crude, threat of rising fuel inflation can never be overcome completely.

Further, if the new government clears the decision on gas price hike, it shall pose further upside risk to inflation. A gradual reduction in complex fertilizer subsidies, in fact any subsidy for that matter, is also a threat to inflation. Take the case of reduction in fertilizer subsidy on inflation. As subsides reduce, fertilizer companies increase the end product price, which burdens the farmer and ultimately the end consumer in the form of higher food inflation. As India is slowly moving out of the subsidy era, inflationary threats continue to remain.

Higher inflationary environment in general means interest rates are likely to remain high. Thus, RBI is likely to remain more hawkish than dovish in the near to medium term.

What does this mean for the economy?

Higher interest rates deter capex cycle. They slow down investments and hurt growth. And with RBI having prioritized inflation over growth, interest rates may remain high. Thus, growth may continue to take a backseat.

However, it should be noted that interest rate is just one of the factors that impacts investment cycle. Other factors like better policy making and reduced bureaucracy also matter. And it is the government which is responsible for managing them. If the government improves policy making and ease of doing business, then the interest rate hindrance can be easily overcome. This shall kick start the growth cycle.

Did you expect RBI to reduce rates in yesterday's monetary policy? If not, when do you think RBI will eventually reduce rates? Let us know in the Equitymaster Club or share your comments below.

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IIP or Index of Industrial Production is an index that spells out the growth of various sectors in an economy. However, in recent periods the IIP index has lost its sanctity. For severe volatility in the number has reduced its credibility. The sharp swings and massive revisions have impaired the index. A glance at the chart below fairly corroborates this view. A leading financial daily reports IIP comparison of past five months of 2013-14. It clearly shows up the erratic movements in the index. The IIP for September 2013 stood at 2.7% and then fell into negative territory for three consecutive months. Then a new ray of hope emerged with improved industrial output. And the IIP rose to 0.1% during the month of January 2014. The positive index is a good sign. However the inaccuracies in the index calculation cannot be dismissed as a case of oversight. Inclusions of irrelevant items, infrequent data revisions and exclusion of important items have led to the discrepancies in the index. Alas it is high time! The authorities ought to take cognizance of this matter. No wonder, the Planning Commission has woken up to the need of the hour. It has sought for a complete overhaul of the index to rectify these inaccuracies. With a revamp plan in place, we certainly hope to get a clearer and accurate picture.

High volatility in IIP raises questions on its credibility

02:25

Is there anything in the financial markets that's totally transparent and free of rigging of any kind? Well, you'd be hard pressed to find any worthwhile example we reckon. We all know how the US Fed seems to be manipulating the interest rates. And the phoniness of the official inflation numbers and also the GDP numbers have been flagged by many an expert for quite some time now. Therefore, given all this rigging, it hasn't come as a surprise to us when Michael Lewis, one of the most well known financial writers currently has drawn our attention to a type of rigging in the stock market. As a matter of fact, his latest book has one such rigging as its central theme.

He has argued that the US stock market now faces a near routine rigging. The modus operandi is awfully simple. Here, there are elite traders that have access to high speed network. And this network figures out what other small investors have just ordered, order it first and then raise the price just before the order of the small investors is complete. In other words, front run a trade and that too in a totally legal way. Of course the pay off from such an approach is not very high. But spread it over hundreds of thousands of transactions and we could well be talking millions and billions of dollars worth of gains we believe. Clearly, looks like man's greed knows no bounds.

03:05

Janet Yellen has been seen as the central banker who will toe in line with the predecessor Ben Bernanke. From day one, she has supported the Federal Reserve attempts to make the liquidity scenario easier to support employment. It now seems that she is still not satisfied with the billions the US Fed has already pumped into the economy. As per Bloomberg, Yellen believes that the Fed has not done enough to combat unemployment. This certainly sounds ridiculous after having held interest rates near zero for more than five years. And at the same time pumping up its balance sheet to US$ 4.23 trillion with bond purchases. Fed chief Yellen is now inclined to keep interest rates low for a prolonged period to boost employment. Unemployment in the US was 6.7% in February, up from the 6.6% level in January 2014 that was the lowest since October 2008. While we do not think the Fed chief's decision holds much water it could certainly mean more cheap money coming into emerging markets.

03:35

The pace at which credit is growing in China has spooked many experts, investors and economists around the world. Therefore it makes sense to determine how serious this issue really is. Let us look at some of the economic data first. As reported in an article in the Financial Times, Chinese exports as a percentage of GDP has considerably shrunk in the period 2007-2011. At the same time, share of investment over the same time has risen. In addition to this, China's GDP growth has slowed down to around 7% in 2013 as compared to 10% in the past decade. The rise in investment has largely been a product of expansion in credit and debt. What more, credit has expanded not necessarily through the traditional banking channels but through shadow banking activities. The silver lining for China is that it is a net creditor and has exchange controls. This means domestic creditors cannot take their money out of China.

Moreover, even though debt has bloated, the repercussions may not be as severe as in the West simply because those markets are saturated whereas the dragon nation still has potential to grow. Having said that, credit cannot grow indefinitely in China unless it is also followed by growth. The latter in the last couple of years has slowed down. Thus, it is only a matter of time before the pace of credit expansion also falters. Thus, the only long term solution to China's ills would be the emphasis on reforms.

04:10

In less than a week's time, the much-awaited general elections will kick-start in India. Political parties are leaving no stone unturned to woo the 814.5 m electorates in the country. And it goes without saying that a lot of money is being spent in this game for power. As per certain estimates reported by Financial Express, the total spending on polls is set to be about Rs 300 bn. Never before in the history of this country was such a huge amount spent. And it is worth noting that about one-third of this amount is estimated to be in the form of 'black money'. The unfortunate part is that a lot of this illegitimate money would be misused for voter mobilisation and as 'note-for-vote'.

04:30

In the meanwhile, the Indian stock markets are trading buoyant. At the time of writing, the benchmark BSE-Sensex was up by 67 points (+0.3%). Pharma and oil & gas were leading the gainers, while FMCG and metal were the major losers. Most of the Asian stock markets were trading in the green led by Japan and China. European markets have opened the day on a mixed note.

Keeping rates steady is a colossal blunder. The CPI index has DECLINED for 3 months in a row. We are in DEFLATION!The Rupee is strong which will lead to more deflation. the monsoon is irrelevant as it has a negligible impact on global agricultural prices. Indian prices of oils, oilseeds, sugar,cereals, crude oil, gas,copper, ironore are all connected to global prices through trade. Our index is largely made of commodities.
Even prices manufactured goods are 60 to 70% dependent on the rawmaterial commodity prices. Only a steady Rupee can kill inflation.High interest rates kill growth and have zero impact on Indian infltion because of the preponderance of globally traded commodities in our inflation basket.

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